The
Truth Behind Oil’s Recent Price Spike, Kent Moors
As I’m writing this, the West Texas
Intermediate (WTI) has surged almost 3 percent for the day, over 5 percent
since the close on Monday, and is up 6.5 percent in a week – their highest
levels since the beginning of February.
Meanwhile, Brent has registered
equivalent gains of 2.9 percent, 4.6 percent, and 6.5 percent, respectively. Now, there are two essential reasons why
the price improvement is taking place, and both bode quite well for investment
returns in the sector.
Oil’s “Usual Suspects” - The first reason goes to the “usual”
suspects…U.S. production levels; Geopolitics; Demand; And currency exchange
rates. These are familiar, traditional, and market-based considerations.
American extraction came in much lower
than expected for the week. Estimates from the Energy Information
Administration (EIA) showed a decline of 2.6 million barrels. However, analysts
had expected a 2.5 million increase.
Now, a variance like this is hardly
news.
In fact, the EIA and analyst
expectations tend to move in different directions over 60 percent of the time. Somewhat
unusually this time around, however, was the convergence between the EIA and analysts on the
two-other major weekly figures – gasoline and distillates (diesel and
low-sulfur heating oil). Only crude oil showed a marked disparity.
Now, geopolitics can once again be used
to explain all manner of events in the energy sector.
This time, we can point to concerns
over…
• Rising instability in the Persian Gulf
as the Saudi Crown Prince visiting D.C. as Trump considers ending the Iranian
Nuclear Accord;
• Washington considering sanctions
against an imploding Venezuela;
• The intensifying Libyan conflict;
• Chinese saber-rattling in the South
China Sea;
• And ongoing Nigerian domestic
problems, to name a few of the more compelling,
I often note that geopolitics are no
longer an outlier when considering the energy markets. Rather, the uncertainty
resulting from cross-border and global unrest is an ongoing staple element. Nonetheless,
pundits often use it as a catchall for anything they have difficulty
explaining.
Geopolitics may influence how one
regards the potential future oil availability, but until the oil flow is
actually impacted, its influence is more apparent than real.
The Misunderstood “Yardstick” - Demand remains one of the most
misunderstood yardsticks to measure oil. Yes, the balance between supply and
demand certainly does influence price, but the real importance is the effect it
has on the amount of excess supply.
Oil requires available volume beyond
what the market needs at any time to narrow the pricing range. Of course, too
much excess volume will prompt prices lower, while the opposite will drive
prices higher.
When we speak of a “balance,” it always
assumes the availability of excess volume beyond immediate requirements. That
balance is rapidly emerging and, in some regions, may have already arrived.
Finally, currency exchange rates speak
about the foreign exchange rate for the dollar. The vast majority of all
international oil trade is denominated in dollars. When the value of the dollar
declines against other currencies (especially the euro), the dollar value of a
barrel of oil increases. And recently, the weakening dollar has resulted in
that upward pressure on crude.
Oil’s Perceived Price - Remember, the one common thread
permeating all of this is how the forward price of oil is perceived by the
trader. Here, as I have noted, traders will peg the price in a future contract
to the expected cost of the next available barrel of crude.
Options – and more exotic derivatives –
are then applied as insurance against movements in either direction. Throughout
all of this, the perceived direction of prices becomes the driving engine in
traders’ actions.
If that perceived trend is moving up,
traders will compensate by setting future prices based upon the expected most
expensive next available barrel. The opposite, as in the least expensive
barrel, governs the mindset if the trend is moving lower.
Keeping this in mind, therefore, the
most direct way of concluding which way it will move is rather straightforward.
It involves the number of short versus
long contracts being exercised.
A short is run if the trader expects the
price of any underlying commodity or equity is going to decline. Conversely, a
long contract anticipates the underling will rise in price.
Until last week, shorts held considerable
sway.
That changed abruptly on Thursday with
long contracts taking over.
The New “Head Honcho” - Longs are now driving the market. Another
result of this transition is the need for holders of shorts to liquidate
positions, requiring that they go back into the market and purchase contracts. That
serves as another upward pressure on prices.
All of this evens out at some point into
a new equilibrium. After all, that is what trading markets
always seek. But the important point to remember is
this:
It’s not the ceiling, but rather the
floor of the pricing range that actually determines the direction of movement. Once the dust settles, if the floor is
rising, so are the pricing expectations. That is what we have at the moment.
And that’s all we need to make money with targeted moves.
Comments
This article explains
how oil prices climbed from below $40 /bbl in 2016 to over $50 /bbl in
2017. The current rise from $50/ bbl in
2017 to $70 /bbl in 2018 is due to inadequate pipeline capacity in the US.
Norb Leahy, Dunwoody
GA Tea Party Leader
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